Monday, February 03, 2014

I began writing this post several weeks ago when equity markets around the globe succumbed to profit taking. Much of the catalyst was attributable to currency issues in a number of the emerging economies with the China PMI report tipping the scales toward this profit taking environment. China's PMI report last month indicated that the country's manufacturing economy had contracted in January versus the report in December. The China January PMI was reported at 50.5 versus 51 in December. Industrial output fell below 50 at 49.5 versus 50.5 in December. This morning China's non-Manufacturing PMI declined to 53.4 versus 54.6 in December. Readings below 50 indicate contraction. As can be seen in the below chart, readings below 50 have been more the norm than not since 2011 so why all the concern now?

Then this morning the U.S. manufacturing PMI came out and was weaker than expected but still indicating expansion. As the below chart indicates the PMI has been in expansion since the end of the most recent recession except for November 2012 when the PMI reading was 49.5 and we know how the market performed in 2013.

"An emerging meme posits that the recent weakness in quite a few emerging market currencies (e.g., Argentina, Venezuela, Brazil, Chile, Turkey) is a replay of the S.E. Asian currency crisis of 1997-98, and as such this may persuade the Fed to back off on its intention to continue its QE taper. I disagree, because there are some very important differences between now and then."

The Grannis article highlights the issues that have been developing in some of the emerging countries that led to recent currency weakness and is a good read for investors.

We believe investors should evaluate these emerging market developments in the context of overall economic activity around the globe. It is not uncommon, or better yet, it is normal for economies to transition from a recovery phase, an expansion phase and ultimately a contraction phase. Importantly, investors should evaluate where the various economies around the globe fall in respect to the economic cycle and allocate investment dollars within their portfolio based on these conclusions.

At the end of 2013, Fidelity research estimates several of the major global economies reside in positions within the economic cycle as noted below.

The implications of this transition to different phases of the economic cycle are important for investors as they allocate equity funds to the sectors that will benefit the most or least from the specific phase of the cycle in which the economy may reside. This is not a clear cut metric though; however, it is helpful in guiding ones investment allocation. We wrote about this in early 2011, Sector Rotation And The Economic Cycle, and provide a link to a Fidelity white paper that contains a more in depth discussion on this topic.

Because these sector transitions are not clear cut, at HORAN we review a number of variables one of which is earnings revisions by analyst. As the below table shows, the largest positive revisions have been in the Utilities and Telecommunications sectors. For the month of January, from a sector contribution perspective, both of these sectors were top three in terms of contribution as detailed in S&P's January Index Dashboard report.

Looking ahead, investor should take some comfort in Q4 2013 earnings reported by S&P 500 companies to date. A total of 249 S&P 500 companies have reported to date for the fourth quarter. There seems to be quite a bit of chatter about companies lowered guidance going into Q4 so this lowered expectations. Yet, the blended earnings growth rate for Q4 is running at 8.9%. When the quarter began, earnings growth was expected to equal about 7.5% as we noted in our Q4 Investor Letter. In short, we believe companies have been performing pretty well. More importantly, we continue to focus on the forward guidance provided by these firms.

The first read on fourth quarter GDP was reported last week as well. Our belief is U.S. economic growth, GDP, continues at a steady but not over heated pace. The first read on GDP was an annualized 3.2% which is down from 4.1% in Q3 2013. Looking at important components of the GDP report, specifically the consumer, there were some positives.

As reported by Econoday (emphasis in the statement is HCAs), “The increase in real GDP in the fourth quarter primarily reflected positive contributions from personal consumption expenditures (up 3.3 percent), exports (up 11.4 percent), nonresidential fixed investment (up 3.8 percent), private inventory investment, and state and local government spending that were partly offset by negative contributions from federal government spending and residential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased.”

“The deceleration in real GDP in the fourth quarter reflected a deceleration in private inventory investment (will need to add to inventory going forward if demand continues?), a larger decrease in federal government spending (a longer term positive), a downturn in residential fixed investment, and decelerations in state and local government spending and in nonresidential fixed investment that were partly offset by accelerations in exports and in PCEs and a deceleration in imports.”

Since the consumer accounts for 70% of GDP, Econoday’s conclusion, “While the fourth quarter was moderately healthy on average as measured by GDP, monthly data showed softening late in the quarter — notably for manufacturing and housing. However, the consumer appears to be a little more optimistic and the consumer sector may be carrying the economic load over the next few months.

So fundamentally, U.S. companies are performing relatively well and we think this continues through 2014. Volatility will undoubtedly continue this year, which seemed to disappear in 2013. From a market technical perspective, a correction or consolidation phase is healthy and we do believe the recent focus of the selling is an excuse by investors to take profits in some of their equity position. Additionally, some institutional and hedge fund type managers probably have been caught of guard with the decline in interest rates in the U.S. As a recent article on Business Insider notes, All of the Turmoil In Global Markets Right Now Is Just One Gigantic Hedge Fund Short Squeeze.

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